The Final Frontier
For savvy investors looking to diversify their portfolios, there’s only one place left to go: sub-Saharan Africa.
In popular culture, sub-Saharan Africa may still conjure images of conflict and poverty, yet investors from Wall Street to Main Street are taking a decidedly rosier view. Africa’s surging growth is now well known — the region is home to six of the 10 fastest-growing economies in the world. "Never in the half-century since it won independence from the colonial powers has Africa been in such good shape," gushed a recent special report in The Economist.
If you had jumped on this bandwagon in 2012, you too would be an Afro-optimist. Investors may be thrilled that the S&P 500 index rose a cheery 13 percent in 2012 and is up another 8 percent this year — but this pales next to Nigeria’s stock market, which spiked 35 percent last year and is up another 18 percent so far this year. Ghana (up 24 percent), Uganda (up 39 percent), and Kenya (up 30 percent) also posted strong showings in 2012, and even longtime economic basket case Zimbabwe is up 20 percent in 2013.
But potentially huge returns are only part of the reason to invest in one of sub-Saharan Africa’s budding equity markets. The real play is diversification. As we discovered in our recently released study for the Center for Global Development, African bourses are among the last of a rare and endangered species — stock markets that remain uncorrelated with the major global exchanges.
Diversification is a basic principle of asset allocation. Few investors want to put all their eggs in one basket, thus risking losing it all in the event of a downturn. By spreading around one’s assets in markets that do not move in a synchronized manner, investment risks can be dramatically lessened. However, all this depends on finding markets that move independently from each other.
But an irony of globalization is that as financial markets integrate, they respond to similar events — and thus the benefits of spreading one’s assets across different markets shrinks. These linkages can lead to contagion in times of crisis — such as Mexico in 1994 or Thailand in 1998 — when panic in one country can plunge markets into crisis on the other side of the globe.
The old exotic is already the new normal: Traditional emerging markets, like those in Latin America or Asia, are even more strongly correlated with the United States than we expected. The main U.S. and European stock market indices monthly correlation is about 0.9 (with 1 meaning they move in perfect sync), and Latin America is not far behind. The correlation of the S&P 500 with a weighted average of Latin American stock indices reached 0.86 in 2010, up from a meager 0.15 in 1992. That means, when the Dow moves on Tuesday, it’s highly likely that markets in Sao Paolo and Beijing will follow suit.
By comparison, Africa’s correlation is lagging — and for once this is gives it an advantage. A weighted index of sub-Saharan markets (excluding South Africa) has a correlation of just 0.31 with the S&P 500, less than half of what we find in Asia or Latin America. Thus, an investor won’t be able to diversify his holdings by buying Brazilian or Chinese stocks — but he would be able to do so by investing in Kenya or Ivory Coast. A savvy investor, who can find quality stocks in these places, won’t have to worry much about plunging shares elsewhere hitting these shares.
Furthermore, the lack of correlation among individual African markets provides potentially even greater benefits to a diversification strategy. We found close to zero correlation, for example, between Nigeria and Tanzania or, say, between Ghana and Botswana. That’s more good news for smart investors looking to spread their risk by investing in multiple markets.
But the clock for exploiting this anomaly is ticking. As markets integrate, African stock returns are converging with global benchmarks: Their correlation with the S&P 500 was close to zero a decade ago, but has steadily risen. As more investment has moved into Africa, they have become, ironically, more closely in sync with external markets. Fortunately, African markets may not reach total convergence any time soon, but their usefulness as a way to spread around risk is certainly going to continue to diminish. And as African investors start to place their money into neighboring countries, the intra-regional benefits will likely decline as well.
African stocks are not for all investors. Volatility of returns remains relatively high, and liquidity is still shockingly low. Large institutional investors in particular will find it difficult to enter many of these smaller frontier markets, just because of their sheer size. Ghana’s exchange, for example, may be posting impressive returns of late — but the market trades less volume in a whole year than the New York Stock Exchange does by lunchtime. Even finding blocks of shares larger than $5 million can require patience and can exclude some of the biggest players..
But there are a growing number of boutique funds that specialize in the region, which are well placed to manage the challenges. EPFR Global, a fund flow data provider, reports that these funds and others managed by major global banks have already begun pumping money into Africa-dedicated equity funds — nearly $900 million in December 2012 alone. Just last week, Barclay’s South Africa-based Absa Asset Management announced plans for a new $100 million regional stock fund. (If you are a small investor and want to try for yourself, here’s investinginafrica.net’s Ryan Hoover’s advice for how to start in Botswana.)
African countries can also take steps to better exploit this growing investor interest. The first is, ironically, getting more domestic investors — it’s never a good sign to foreigners when the locals are shying away. In most African countries, the biggest potential investors are their own public pensions, which are often restricted by rules severely limiting stock holding. Relaxing these rules, as Ghana and Nigeria have begun to do, could release a large reservoir of capital and help to build the equity market investor base.
In theory, there’s also no reason for countries to each have their own stock market. The economics suggest they should merge into one large regional exchange, sharing costs and boosting overall liquidity. But the political logic runs the other way: stock markets have become important symbols of a modern economy — the contemporary equivalent of a national airline — so each country wants to have its own.
As an interim step, markets can encourage cross-listing, which can offer the best of both worlds. This practice is already reaping benefits: The Botswana Stock Exchange, in addition to its 24 local companies, also trades 14 South African-listed shares, which boosts its total market capitalization more than nine times.
The biggest hurdle holding back these markets from further expansion is the limited size of their own host economies. If a country’s entire economy is only $20 billion (roughly the gross domestic product of Tanzania or Uganda) or even $35 billion (approximately Ghana or Kenya),
then it will likely only have so many private companies large enough to attract big international investment. Even Nigeria, with a GDP of $235 billion and a stock market capitalization of $66 billion, has only seven companies over the $2 billion minimum which qualifies them as a "midcap." But if Nigeria can maintain its high rates of economic growth, this dearth of globally attractive listings won’t last for long.
In the meantime, African officials and fund managers seeking to bolster capital inflows should exploit one of the very few advantages of being outside the global economic mainstream by highlighting the independence of its equity markets. In so many ways, the world economy is stacked against small markets and small investors. Here is one way in which the little guys — at least for now — can gain an edge.
Todd Moss, a former deputy assistant secretary of state for African affairs, is senior fellow at the Center for Global Development.